Monday, November 19, 2012

I think the whole idea of endogenous money is vastly overrated and the idea of exogenous money is vastly underrated.

Granted, the term is (intentionally, I think) vague. That's why I say "under-" and "over-rated" rather than "right" and "wrong". We've had some readings on it which I've only semi-attended to, and after a whole class discussing it today I am not very impressed by the whole debate.

If you want to say central banks care about interest rates, I'm fine with that. If you want to say that interest rates impact aggregate demand and that influences the broader definitions of the money supply, I'm fine with that. But monetary policy is still done by buying and selling high powered money (as far as I know - I've never talked to someone at the OMO desk), and it's done that way because while causality could run both ways (think of the old use of the discount window or Bagehot's dictums as an example of interest rates "causing" money creation), that's not how it works. Of course there is some target interest rate in mind (and THAT is only what gets churned out of some target inflation rate) - but you buy and sell stuff at the OMO desk because it causes that target interest rate to come to fruition.

31 comments:

My guess would be that the endogenous / interest rate perspective makes it somewhat easier to figure out the effects of monetary policy in extreme scenarios (ZLB, unconventional policies, etc.), which become a somewhat less clear if you start from high powered money and then go through multipliers to get to the actual money supply (e.g. claims of QE causing hyperinflation).

Endogenous money is typically about much more than the manner by which central banks perform OMOs. You are correct that central banks typically buy and sell high-powered("outside") money to target a federal funds rate. However, a theory of endogenous money would argue that does little to control the inflation rate or aggregate demand within the economy. Instead, private banks create "inside" money (deposits) through lending that adds to aggregate demand and can create inflation. After lending, banks ensure they meet reserve requirements and the Fed ensures the entire banking system has enough reserves to maintain its target interest rate.

From this perspective, a money multiplier with respect to OMOs does not exist. Further, money and money-like instruments can be perceived as non-neutral, even in the long run. In these ways and more, the distinction between the two theories is far greater than you appear to let on.

(Note: Through QE, the Fed has been buying Treasuries and Agency-MBS, which are not forms of high-powered money)

re: "From this perspective, a money multiplier with respect to OMOs does not exist. Further, money and money-like instruments can be perceived as non-neutral, even in the long run. In these ways and more, the distinction between the two theories is far greater than you appear to let on."

Why doesn't the money multiplier exist? I'm not sure I'm connecting the dots. The money multiplier is practically a definition. This really depends on what you're calling the multiplier. Mankiw calls it the reciprocal of the reserve ratio - and that's how I've always thought of it. In that case, you seem to be wrong. Critics will often call the multiplier the reciprocal of the reserve requirement. In that case you're right I suppose but that just doesn't seem to be a very sensible definition. Wikipedia seems to be schizophrenic on the question - in their money creation article they tell people it's the reciprocal of the reserve ratio. In the money multiplier article they tell people it's the reciprocal of the reserve requirement.

I agree money is non-neutral in the long-run but as far as I know there's no reason you can't agree with that and an exogenous money supply.

So unless you take a definition of the multiplier that a leading textbook author rejects and doesn't make much sense anyway, I'm not sure this is right.

From Mankiw:"The amount of money the banking system generates with each dollar of reserves is called the money multiplier."The relationship described by Mankiw is causal, whereby an increase in reserves causes the money supply to increase by a given multiple based on the reciprocal of the reserve ratio.

My claim is that the money multiplier doesn't exist in the sense that it holds no causation value for broad supply of money, inflation or NGDP. If you're take is that it simply states a ratio between two values than I wouldn't disagree, but the concept would seemingly lose any meaning in supporting monetary policy.

I'm not sure I'm getting what you mean (I'll read the link). The "money multiplier" I suppose is no more "causal" than the fiscal multiplier is - they're just frameworks for talking about how reserves cause broader money creation and how investment or government spending causes output growth. Is that all you mean by "causal". The multiplier itself is just a description of the parameters of the relationship between reserves and broader monetary aggregates. The important thing is that reserves cause new money to be created, and manipulating reserves is how a target interest rate is achieved (target interest rates don't cycle back to generate a certain amount of reserves, as some suggest).

re: "If you're take is that it simply states a ratio between two values than I wouldn't disagree, but the concept would seemingly lose any meaning in supporting monetary policy."

OK I'm really misunderstanding you - that seems to be the only sense in which it has meaning for monetary policy!

Does velocity have no meaning either because we can define it as a ratio of other quantities.

My way of thinking about it is this (correct me if I'm wrong - I've never worked in a central bank... this obviously presumes the Fed - others have other mechanisms):

Q: How is monetary policy actually doneA: Bonds are bought and sold for reserves

Q: What does this do?A: It influences the amount of broader monetary aggregates that banks create in response for demand for loans

Q: How does it do that?A: Well they only keep a portion of their assets in reserves, the rest they lend out. It's because they have a ratio of reserves in mind that additional reserves generates additional loans

Q: So we could take the reciprocal of that desired reserve ratio to understand how reserves propagate through the system?A: Exactly

Q: Is that a little tautological?A: Yes - we use lots of tautologies to more clearly define relations between economic magnitudes.

Q: Why do central banks do this?A: To manipulate the loanable funds market in order to reach an interest rate that they want.

re: "The important thing is that reserves cause new money to be created"

This is where I think we disagree. I'm stating, along with Post-Keynesians and others, that reserves don't cause any new money to be created by the private banking system. Causality runs the other direction. Banks create deposits by making loans and the Fed accommodates the entire banking sector's need for reserves to maintain its target rate. Its important to note that reserves are only applied to certain types of deposits and that several countries, such as Canada, have no reserve requirements.

Regarding the questions, I would argue no loanable funds market exists and reserves don't act as a realistic constrain on lending. Banks can create loans at will and are only really restricted by capital constraints and the willingness of borrowers to accept their credit (made easier by FDIC insurance and govt guarantees). The effect of monetary policy is therefore to influence the demand for loans and the willingness of banks to lend, not their ability.

Kaldor's book, The Scourge of Monetarism, is a fantastic read on the subject.

1.A. If reserves are not created by the central bank loans will ultimately be made.

1.B. If reserves are created by the central bank, loans will be made according to how banks value holding reserves vs. satisfying demand for loans.

Alternatively:

2.A. If banks make loans and thereby create new deposits IT DOES NOT follow that reserves are going to be created. They may be. They may not be.

2.B. If banks DON'T make loans, lots of reserves could be made by the central bank if it wanted.

I can't comprehend how - if those four statements are true (and I think the are) - it makes sense to say that causality runs from money to reserves. This word people use - "accomodate" - is a way of admitting the above four claims but wiggling around calling it "causal", which it plainly seems to be.

re: "Its important to note that reserves are only applied to certain types of deposits and that several countries, such as Canada, have no reserve requirements."

I don't quite agree with this. Reserve requirements are only applied to certain types of deposits (and in certain countries). Reserves are relevant for all deposits. Reserve requirements - if and when they come into play - just put a lower bound on reserves.

From the Fed:"Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.""Reservable liabilities consist of net transaction accounts, nonpersonal time deposits, and eurocurrency liabilities. Since December 27, 1990, nonpersonal time deposits and eurocurrency liabilities have had a reserve ratio of zero."

I'm not sure I fully agree with 1B or 2A. Before tapping the discount window, banks will try to borrow reserve through the interbank market. If their is a shortage of reserves, banks will bid up the effective federal funds rate to the discount window rate. Banks always have the opportunity to borrow reserves from the Fed through the discount window. Banks must may a premium over the Fed funds rate, but reserves are available.

As for 2B, I agree with your statement but fail to see how this supports causality running from reserves to money. It would appear to imply there is no real causality in that instance.

I'm not sure what you're intending to show with your Fed quote. That seems to confirm my point. Reserve requirements are what vary by liability type and country. Reserves can be held by a bank for the sake of security no matter what sorts of liabilities it wants to hold reserves for.

My understanding is that the discount window is rarely used. That would be a genuine example of endogenous money. But that was de-emphasized since the 1920s. I guess I'm not understanding how this poses problems for 1B or 2A so long as the discount window isn't really a policy tool.

The point with 2B is that causality doesn't run from money to reserves (as with 2A). 1A and 1B show that causality does run from reserves to money (loan demand, desired reserves, etc. of course determine the strength of the relationship).

re: "1.A. If reserves are not created by the central bank loans will ultimately be made."

How does this show causality from reserves to money?

Regarding the discount window, it is rarely used because the Fed either adjusts the amount of reserves in the system or its target rate before banks are able to bid the effective fed funds rate up to the discount window rate. The central bank therefore elects to avoid usage of the discount window by accommodating the required reserves for any given target interest rate. Loans affecting reserve requirements are made well in-advance of the actual application of those requirements.

Agree with Joshua that endogenous money is about banks lending money into the economy.

Endogenous money explains why having a trade deficit and a budget surplus at the same time might be a problem. Unless the private economy is suddenly able to support higher levels of investment we're likely to face bubbles or recessions.

It's also why people say the central bank must act (in absence of "unconventional" monetary policy) through the expectations channel at the zero lower bound. (Although the trade deficit doesn't have a zero lower bound, but attempts to devalue the currency might be considered "nonstandard" policy.)

It's true that there is a false dichotomy between exogenous and endogenous, but there is also probably a false dichotomy between monetary (and especially "unconventional" monetary policy) and fiscal policy. (I'm unsure how Wallace neutrality might effect my assessment.)

Basically money is overdetermined. Underlying conditions, bank lending, and fiscal policy affect inflation and deflation and the central bank adjust rates and monetary policy in response which in turn affects those three things and vice versa.

re: "Unless the private economy is suddenly able to support higher levels of investment we're likely to face bubbles or recessions."

Again, this gets to vague ideas about what "endogenous money" means. Keynes, for example, has an exogenous money supply conception and is entirely capable of writing a sentence like this.

re: "Basically money is overdetermined."

I definitely agree with this - I used this sort of language a little over a year ago to talk about the potential for persistent unemployment: http://factsandotherstubbornthings.blogspot.com/2011/04/nick-rowe-brad-delong-and-me-on-whack.html

The basic sectoral balance equation, derived from NIPA, is:Net Private Savings (S-I) = Government Deficit (G-T) + Net Exports (X-M)From an accounting perspective, if the govt runs a budget surplus and a trade deficit, the private sector must be in deficit. The budget surplus and trade deficit are often considered demand leakages, hence private sector borrowing/credit expansion is necessary to make up for the shortfall in demand, otherwise GDP presumably falls.

This situation arose in the late 1990's and was met with a significant rise in private sector debt growth that aided bubble growth. Unfortunately, the private sector cannot increase debt/GDP indefinitely and the current rise in savings (not fully offset by reductions in the trade deficit or budget deficits) has led to a deep recession and slow growth recovery.

Right - it's why this goes hand in glove with endogenous money that is kept vague. Keynes is an example of someone who acknowledges all the points in your first paragraph with an exogenous money supply.

From Scott Fullwiler, on my blog:"FYI, while the CB does do OMOs, these are 100% defensive to accommodate banks' demand for reserve balances at the target rate. The "permanent" operations--those that are not reversed--are 100% for the purpose of offsetting the drain in reserve balances that occurs when banks purchase currency from the Fed to replenish vault cash. The "temporary" operations are repos intended to offset some change to the Fed's balance sheet affecting reserve balances that day, or some swing in the demand for reserve balances due to increased payment settlement needs, etc. So, again, the operations are totally defensive, not offensive, as Kuehn's comment suggests. And they must be that way unless the Fed sets the target rate equal to IOR, as it has since 2008--that's the only way the Fed can have direct control over the qty of reserve balances."

Does that sound right? If so, maybe I've been misinterpreting your comments.

I know that's how people like Scott talk about it, but it seems completely backward to me. The OMOs are what are done to achieve an interest rate that the Fed is interested in maintaining. To talk about them as "defensive" or "accommodating" when they are the active policy lever seems wacky to me.

To a large extent this is semantic, right? The gears turn the same way whether you work the problem backward or forward. I just don't get why endogenous is the more obvious way of describing it than exogenous. Announcing a fed funds rate doesn't do anything at all to the level of reserves. After all - the fed doesn't set that rate - banks do. Announcing a purchase or sale of bonds will absolutely affect the fed funds rate whether that rate target is announced or not.

It may be semantics, but I'm not entirely convinced. I agree with you that the interest rate is set endogenously and for some practical purposes it may not matter whether the Fed acts offensively or defensively.

However, the area I believe it does matter is when considering the equation MV=PY (which seems critical to Market Monetarists/NGDP targeting). As vimothy pointed out, I tend to hear "endogenous" and "exogenous" money in reference to the manner by which M is determined. I'm arguing that M is determined endogenously, given an exogenous interest rate. I often think of "exogenous" money as implying M being set by the central bank. This appears to have significant consequences for determining whether or not the central bank can accurately target PY (NGDP).

I'm not sure at this point which side your representing, if either. I think that distinction is important though for countering monetarism and others who base policy decisions off that relationship.

OK, and M in MV=PY is a broader monetary aggregate. I think everybody agrees that the central bank doesn't perfectly control those aggregates.

I'm not sure whether I'm interested in "countering monetarism" or not. I've certainly made the point before that all of those magnitudes in the equation of exchange are variable - that certainly would complicate any monetarist project.

I'm sure I've asked you this before, but how did a guy with your kind of endogenous money/post keynesian (?) leanings get caught up with GMU's economics department?

Maybe my reading list is proportionally over-represented with monetarists, but they appear to be making in roads with the Fed/mainstream. I wish everybody agreed that the central bank doesn't even close to perfectly control those aggregates.

Since I wanted to stay near DC for a PhD, the two schools that stood out personally were American and GMU (not the typical choices for most, I know). While I hold an endogenous money/Post-Keynesian leaning (which favored American), I am also intrigued by Austrian views of uncertainty and subjectivism (especially Lachmann's). Anyways, having gone to pretty liberal schools previously, I thought GMU presented a greater personal academic/intellectual challenge.

Since my nudge didn't work. Instead, two man with a hammer comments, it is time for some basic Minsky, from Wiki:

Financial instability hypothesis

According to Hyman Minsky, the money supply is the sum of high-powered money and demand deposits. Minsky’s financial instability hypothesis claims that this quantity is inherently unstable. His "financial instability hypothesis" starts with a high level of investment due to a high rate of profits. These profits provide cash flows to service debt which in turn yields more profits and leads to a boom in equities. Rapid output growth forces firms to take on more debt to expand production. Over time, investors come to underestimate financial risk during the boom. Eventually, interest rates surge, which forces debtors to roll once-affordable interest payments into ever-higher principal amounts. If rates remain high, more and more investments turn into "Ponzi schemes". Financial euphoria slowly changes to financial panic; lenders start to lose confidence in the future, asset prices decline. Eventually, borrowers can no longer refinance, gross profit eventually collapses and investment falls or even stops.

Consequently, over a period of time an economy can become susceptible to debt deflation. To avoid deflation and a lasting depression, the central bank is expected to ‘bail out’ the financial system by providing fresh reserves to increase liquidity and reduce cost of funds. Changes in the quantity of money have a limited direct impact on the economy as a means of mitigating financial crisis. Conversely, financial crises do not depend on a rapidly increasing money supply.

I'm not too sure what the problem is. Common sense and basic optimality conditions tell you that, if the central bank targets an interest rate, it cannot simultaneously target a money supply level or path, since the return on bonds and the quantity of money demanded by the market are jointly determined.

The fact that money enters via OMO does not mean that the money supply is "exogenous", i.e., set by the central bank. If the central bank is committed to an interest rate target, then it must passively supply whatever level of money will satisfy the market demand function at its target rate, which is what most people mean by "endogenous".

Right - the target is the interest rate. Nobody cares about targeting a money supply. I'm not sure what I've said to make you think I'm saying that.

The Fed does control the base money supply, though. It takes its target interest rate and backs out of that whatever OMO activity is required to hit the target. It's an interest rate target, and a money supply instrument (and presumably the real target they have in mind isn't even the interest rate - it's an inflation and unemployment rate, and they back the interest rate out of that with a Taylor Rule).

The question is - does base money fluctuate in response to an interest rate that the Fed sets, or does the base money fluctuate by fiat in an effort to hit a certain interest rate?

The latter, of course.

I can't see how that's anything other than exogenous money and money causing a (desired, targeted) interest rate. Anything else sounds backwards and you have to use vague words like "accomodate" to make it sound like causality has been reversed.

What does the Fed want: a particular interest rate.What does it do to get what it wants: manipulate the level of reserves.

If this is not causality from reserves that are exogenously set to an interest rate, I don't know what else "causality" could mean in a policy context

What I would think most people mean by "endogenous money" is that the government cannot determine its level, whereas "exogenous money" implies that it can.

Under a regime that targets the money supply, the IR would be endogenous and the money supply exogenous. Under a regime that targets an interest rate, such as in most modern developed countries, the reverse is true.

Leaving aside the mechanics of central banking for a moment, basic theory tells you that in equilibrium, the marginal return on money and the marginal return on bonds must be equal. Meaning that if you raise or lower the supply of money, then you must also lower or raise the return on bonds.

Of course, you are quite correct that the central bank "controls" the supply of money in the literal sense of issuing it, but it does not "control" it in the sense of freely choosing whatever level it likes.

Given its chosen target interest rate, it has to supply the equilibrium quantity determined by the market demand function.

I agree with vimothy here (and maybe we are misunderstanding you, Daniel). I completely agree the central bank currently uses reserves to target an interest rate. However, that is very different from saying "that reserves cause new money to be created" (unless you mean the reserves are new money but have no effect on bank creation of money).

Exogenous money typically refers to the broad money supply (not just the monetary base) being determined by the central bank. That may be different from your usage, in which case it might help if you clarify. This theory also leads many to imply that QE, which doesn't alter the target rate, will influence aggregate demand, inflation and NGDP. In your view, what would the basis and effect of QE be?

Fair point and I may have overstated my view. I agree that QE can be effective under an IR target w/IOER, but don't think that effect stems from increasing the ability of banks to make loans (unless the Fed purchases poor collateral at above market prices). I would argue potential effects arise in part from altering the maturity and interest income of private banks, as well as expectations about future prices.

Reserves are just another cost decision, along with staff, other inputs, etc. The availability of them does not enter into a bank's lending decisions, which is done purely on a bookkeeping basis. At the end of some time period, a bank will settle its reserve decisions, as with any other cost. The price of reserves can be altered to make banks lend less/increase the interest rates, but this is only in a similar way that some other 'supply shock' might.

When banks create a loan M1 expands. When it is 'paid back' M1 contracts. This happens every day, largely independently of the CB and is a far bigger variable than the 'V' in the tautologically QtoM equation.